La dramatización como potencializadora de competencias

Initially, it is useful to refer to Trichet (2003), who recognizes two main reasons explaining the growth in asset prices and wealth effects during the last fifteen years. The first is the dramatic change in asset valuations stemming mainly from the rise in the stock prices of the so-called “new economy” during the mid 1990s and their collapse in 2000105. The second refers to the effect that widespread share-ownership

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Besides the United States (where the above is well documented) the rise in stock prices has been considerable even in Europe, where the influence of the “new economy” had been relatively modest (Trichet (2003), p. 15).

in several industrialised countries has on the influence of the above changes in asset valuations to private spending relative to the past106 (Trichet (2003), p. 15). These issues raise the concerns of whether monetary policy should react to movements in asset prices. Large swings in asset prices may jeopardise the principal monetary policy objective of price stability and may also hamper financial stability, which is of major concern to central banks.

Asset prices can play a significant role in the conduct of monetary policy. The role of asset prices in the monetary policy transmission mechanism has been discussed in Chapters 4. Briefly, the effect of changes in the policy rate may be transmitted to asset prices and asset valuation through several channels. Interest rate changes affect expectations about future economic prospects and consequently profit expectations. In addition, such changes alter the set of discount factors applied on profit expectations or used in order to determine the value of assets. Finally, monetary policy decisions may also result in changes in portfolio composition affecting the relative prices of the pertinent assets (Trichet (2003), p. 16).

Furthermore, the wealth effects that changes in asset prices may create, and which exert a significant influence over consumption and investment, pass on to the economy through several channels. Briefly, these channels include a direct net- wealth increase that raises consumption via intertemporal smoothing of consumption from households, changes in Tobin’s q that stimulate corporate investment, or higher collateral values that may lessen external financing constrains and boost spending.

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For example, market capitalization as a percentage of gross domestic product in France increased from 28 percent to 110.5 percent during the 1990s. The share of household equity holdings in financial assets increased as well (Trichet (2003), p.15).

Changes in asset prices may also trigger confidence or expectations channels that affect corporate and household spending decisions (Trichet (2003), p. 16).

Asset price misalignments may also raise the risk of creating financial fragility that can give rise to adverse economy-wide events. Normally, financial innovation leads to more efficient risk sharing, in that risk is undertaken by the most able to bear it resulting, thus, in smoother consumption. However, more efficient risk sharing enhances the potential for concentration of risk to individuals willing to do so. According to Cecchetti (2005) risk concentration, in particular inside leveraged institutions can raise the potential of creating financial fragility. He further remarks that, “as the risk managers of the economic and financial system, policy makers are forced to care about bubbles” (Cecchetti (2005), p. 4).

In the presence of acceptable evidence that asset price fluctuations do not correspond to fundamental levels and with the uncontested recognition of the potential damage asset price bubbles can cause to the economy, both policymakers and academic researchers fail to accept the proposition that bubbles should be ignored. Yet the crucial issue for policymakers is to devise a proper reaction.

It seems illustrative enough to adapt a classification of possible policy reactions provided by Cecchetti (2005) who identifies five suggested responses:

(i) ‘Consider bubbles only if they influence forecasts of future inflation’. (ii) ‘Act only after the bubble bursts, reacting to the fallout of the bubble’. (iii) ‘Include asset prices directly in the price index targeted by the central bank’. (iv) ‘Lean against the bubble, raising interest rates in an attempt to keep it from enlarging’.

(v) ‘Look for regulatory solutions both to keep the bubble from developing and to reduce the impact of a crash should one occur’ (Cecchetti (2005), p. 14).

Each suggested response is considered in more detail below. Initially, it is essential, to stress that asset price targeting, namely, a policy response as in (iii), is rejected by both academics and policymakers as an inappropriate policy reaction. Cecchetti (2005) remarks that policymakers should not target asset prices per se, nevertheless, recognizing that “the proposal that interest rates respond to bubbles is completely consistent with inflation targeting or any other policy framework based on standard stabilization objectives” (Cecchetti (2005), p. 15). This is advocated also, for example, by Cecchetti, Genberg, and Wadhwani (2003) who stress that: “It is our view that central banks can improve macroeconomic performance by reacting to asset price misalignments. We are not now saying … that policymakers should target asset prices” [emphasis is in the original] (Cecchetti et al. (2003), p. 428). As well as their further remark: “We want to emphasize that we are not advocating that asset prices should be targets for monetary policy, neither in the conventional sense that they belong in the objective function of the central bank, nor in the sense that they should be included in the inflation measure targeted by the monetary authorities” [emphasis is in the original] (Cecchetti et al. (2003), p. 429).

Shiratsuka (1999) analyses the appropriate inclusion of asset prices in the price index and concludes that it is very difficult to construct such a price index. The main reasons he gives are first that the accuracy and coverage of asset price statistics are low, that several factors affect the changes in asset prices and, finally, that they are significantly influenced by economic and financial developments. A number of the principal conceptual and implementation-based issues against the inclusion of asset

prices in a price-index relevant for policy (i.e. against asset-price targeting107) present in the academic literature are also concisely given in ECB (2005). In particular:

n, it has to determine the fundamental value of assets promptly and accurately108.

expected to stabilise asset prices, investors’ risk taking behaviour would increase109.

. This may lead to inflation indeterminacy and potentially high inflation volatility 110.

1. Two main reasons are identified against the use of asset prices as a proxy for future goods prices. First, in the case of the inclusion of asset prices in the pertinent price index, in theory, such an index should include all assets, comprising also the value of consumer durables and human capital. Second, movements in asset prices may not relate to future inflation expectations. Then, in a central bank’s effort to device the appropriate reaction to asset price inflatio

2. Asset-price targeting tends to establish a rather ‘mechanical’ policy response that may give rise to moral hazard problems. Since monetary policy would be

3. Asset-price determination and forward-looking monetary policy may give rise to ‘inflation indeterminacy’. Inflation expectations can become self-fulfilling, under certain conditions, when central bank policy responds to asset price movements since asset prices are partly affected by expectations about future monetary policy

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The term ‘target’ usually refers to an explicit central bank objective. However, Cecchetti (2005), for example, uses the term rather loosely to mean either an explicit or implicit objective.

108

See, for example, Filardo (2000), as well as Diewert (2002) and Smets (1997).

109

See Goodhart and Huang (1999).

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4. The benefit of explicitly targeting asset prices which tend to be a ‘deficient’ proxy for future consumer prices seems unclear, if central banks credibly and successfully pursue their consumer price stability objective, stabilising, thus, future inflation expectations111. In fact, this may be considered as the monetary policymaker double- counting consumer price pressures in its information set.

hods used relate the shares to forecasting ability of future consumption prices. The resulting weights may vary considerably with respect to the method in use112.

intless, making the presumption that “monetary policy cannot control the

5. In order to construct a price index that includes asset prices it is vital to determine the weight given to prices of current consumption goods and assets. Traditionally, the method used focuses on expenditure shares, and the resulting weight of asset prices may be higher than 90 percent, leading to a highly volatile monetary policy. Some other met

6. Any attempt by the central bank to affect asset prices in a systematic way seems to be po

fundamental factors which affect asset prices in the long run” (ECB (2005), p. 56- 57).

To sum up, severe asset price fluctuations can potentially destabilise inflation and output to a dramatic extent. More importantly, they pose substantial down-side risks, which cannot be ignored by central banks. However, a suitable monetary policy reaction to misalignments in equity prices, property prices or the exchange rate necessitates an accurate estimation of the relevant numerical size, which is not easy

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See, for example, Bernanke and Gertler (2001), also Cecchetti, Genberg and Wadhwani (2003).

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to accomplish. Nevertheless, as argued by Cecchetti, Genberg, and Wadhwani (2003), not only is such measurement vital in forecasting inflation and growth, but also it is not more difficult than the critical (for policy design) estimation of potential GDP for example (Cecchetti, Genberg, and Wadhwani (2003), p. 440). In addition, Cecchetti (2005) contends that “policymakers do not usually shy away from

important issues just because the solution is difficult” (Cecchetti (2005), p. 20). It is important to address the proposed policy reactions in more detail.

(i) React only if the bubble changes inflation forecasts: This proposition rests in the

face of substantial evidence that a bubble may be in progress. Influential advocates of this proposition have been Bernanke and Gertler (1999, 2001). Their main point is that if monetary policy reacts to booms in asset prices directly, then it faces the possibility of destabilising real output and inflation. Therefore, they view an appropriate monetary policy response only insofar the forecasts to inflation are explicitly affected by the sharp fluctuations in asset prices. Bernanke and Gertler (1999) reach the conclusion that: “The inflation targeting approach dictates that central banks should adjust monetary policy actively and pre-emptively to offset incipient inflationary and deflationary pressures. Importantly, for present purposes, it also implies that policy should not respond to changes in asset prices, except insofar as they signal changes in expected inflation” [emphasis is in the original] (Bernanke and Gertler (1999), p. 78)113. However, Cecchetti, Genberg, Lipsky, and Wadhwani (2000), Cecchetti, Genberg, and Wadhwani (2003) and Cecchetti (2005) reject this conclusion on the grounds of the definition of monetary policy in Bernanke and Gertler (1999, 2001). In particular, they note that the latter address simple rules for

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monetary policy which do not contain the possibility of any responses of interest rates to output gaps, and that if, in fact, the number of possible monetary policy rules is expanded a reaction to asset price bubbles will tend to be stabilizing. Taking into account that monetary policy is essentially the adjustment of the policy instrument in response to shocks so as to reach the relevant stabilisation objectives, Cecchetti (2005) remarks that, in Bernanke and Gertler (1999, 2001) framework (which is the same as in Cecchetti, Genberg, Lipsky, and Wadhwani (2000)) “bubbles are just another type of shock to which interest rate policy should react, and as an empirical

aturity of the bubble. The central bank increases the cost of maintaining a speculative position in the market in order to lead the most stretched positions to liquidation.

policy), in the next phase, it may be the case that even marginal interventions may matter … reacting to bubbles over and above their impact on forecasts of future inflation yields more stable inflation and real growth” (Cecchetti (2005), p. 15). Any attempts of the central bank to “prick” the bubble, i.e. to intervene with a vigorous tightening of policy in order to counter speculation, would take place in a rather late stage in the m

Nevertheless, any such attempts have certain crucial shortcomings. According to ECB (2005), initially, “experience indicates that the market reaction to such an abrupt change in the prevailing monetary conditions is highly unpredictable” (ECB (2005), p. 57). Furthermore, they necessitate considerably large changes in interest rates, which, in turn, bare substantial economy-wide risks. Moreover, in the event of a bubble being resilient to initial corrective action (in terms of aggressive interest rate

trigger a generalised sell-off, that may make the contraction even more intense114. In particular, ECB (2005) argues that “a policy of ‘pricking the bubble’ is not a viable

netary tightening exists that option for a stability-oriented central bank” (ECB (2005), p. 57).

(ii) Clean up after the bubble bursts: According to Greenspan (2002) monetary

policy is inefficient before the bubble bursts and that the appropriate response can only be to eliminate the adverse consequences. In particular, he contends that a policymaker can be certain that a bubble did, in fact, exist only after it unwinds. He also remarks that “no low-risk, low-cost, incremental mo

can reliably deflate a bubble” (Greenspan (2002), p. 5).

In response to this view Cecchetti (2005) argues that asset price bubbles can be identified both theoretically and in practice. He views, for example, large movements in the ratio of housing price sales to rental values or the ratio of market prices to replacement costs as an important signal that a bubble is underway115 (Cecchetti (2005), p. 15). Further support is given by Borio and Lowe (2003) who stress that other ‘financial imbalances’ tend to present in addition to bubbles in asset prices, such as high money-growth or build-ups in debt accumulation. Secondly, as mentioned above, Cecchetti, Genberg, and Wadhwani (2003) point out that the appropriate measurement of asset price misalignments is not more difficult than the critical (for policy design) estimation of potential GDP for example (Cecchetti, Genberg, and Wadhwani (2003), p. 440). Finally, the experience in Australia during (roughly) 1999-2005, where increases in interest rates in addition to effective

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White (1990), among others, attributes the persistence and intensity of the Great Depression to the US Federal Reserve System’s efforts to ‘prick’ an ongoing stock market bubble.

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According to Bean (2003) it would be erroneous to undertake ‘mechanical’ responses to changes in asset prices alone – irrespective of the fact that proportional changes in rents and earnings also take place.

communication of the view that asset price increases (in this case housing) are sustainable, can be an example of effective policy response countering an asset price bubble. In this case the Reserve Bank of Australia managed to contain the increase in housing prices in early 2004 (which remained stable at least for the next two years)

ion116. Cecchetti (2005) suggests that “targeting an index that includes the

after an interest rate increase of ten percent for six consecutive years (Cecchetti (2005), p. 16).

(iii) Include housing prices in the target index: A potential response to bubbles that

may stem from the housing market may be the direct inclusion of housing prices in the price index targeted by the central bank. General arguments against asset price targeting are stated above. However, referring specifically to housing prices, Bryan, Cecchetti, and O’Sullivan (2003) propose that the value of existing homes must have a weight in the price index used by the central bank in order to measure aggregate inflat

acquisition cost of housing would change things dramatically” (Cecchetti (2005), p. 17).

(iv) Use interest rate policy to ‘lean against the bubble’: In this case, in response to

accelerating asset prices the monetary policymaker adopts a more restrictive policy stance than under more normal market conditions and attempts in an early stage to

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Bryan, Cecchetti, and O’Sullivan (2003) argue that policymakers should be stabilizing the cost of lifetime consumption, instead of simply per period consumption, which implies that assets need to be taken into account as they are the prices of entire streams of lifetime consumption. Their analysis suggests that housing, for example, (i.e. giving housing services over a lifetime) must be included in the price index at its current market price (see also Goodhart and Hofmann (2000)). Their analysis builds on the seminal work of Alchian and Klein (1973) who accept that the change in the price of a given level of utility, which includes the present value of future consumption is a theoretically correct measure of inflation. In order to estimate inflation accurately, they argue, a broader price index is necessary than one consisting of only the prices of current consumption goods and services. They view that central banks should target a price-index including asset prices in order to incorporate the price of future consumption. Conversly, Filardo (2000) argues against the inclusion of housing prices in an index of inflation as it would not substantially improve economic performance (he refers to the US, but draws general conclusions).

avoid inflating the bubble which would have been the case with accommodative monetary policy. Therefore, in the shorter term, the central bank may deviate from its

ates, so as to lower the

ts in asset prices influence aggregate demand, altering inflation and the output-gap in the same direction, then monetary policy can, in principle, neutralize these shocks.

price-stability objective, so as to reinforce the prospects of price and economic stability in the future (ECB (2005), p. 58).

Cecchetti, Genberg and Wadhwani (2003) argue in favour of a policy of “leaning against the wind of an incipient asset-price bubble” similar to the policy adopted by the Reserve Bank of Australia in 2003. Among others, Dupor (2005) presents a sticky-price model where firm investment in physical capital exceeds the required level at the face of a bubble in equity prices117. In such an event, the most suitable reaction for the central bank would be to raise interest r

marginal product of capital, and, thus, depress equity prices. Such optimal policy is the one often referred to as ‘leaning against the bubble’118.

Moreover, empirical evidence on this kind of policy is given by Cecchetti (2003) who shows that the U.S. Federal Reserve, in fact, modestly increased interest rates reacting to the stock-price boom of the late 1990s. Cecchetti (2005) argues that asset- price bubbles simply present some “form of destabilizing shocks to which policymakers need to react” (Cecchetti (2005), p. 16). Since movemen

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In his model nominal rigidities distort allocations within the economy for a certain specific time, yet equity bubbles distort saving and investment decisions over time. According to Dupor (2005), since the monetary policymakers possess a single interest rate instrument and face those two problems, the optimal policy needs to react to both distortions.

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According to Bean (2003), for New-Keynesian macroeconomic models this is a general result. Furthermore, in order to avoid credit crunches central banks would generally resort to increases in interest rates.

ECB (2005) notes that “a policy of ‘leaning against the bubble’ would appear more attractive the higher the costs that the central bank ascribes to large, fundamentally unjustified swings in the valuation of assets and the more serious the risk that – if left unchecked – market movements would tend to gain momentum as time progresses” (ECB (2005), p. 58). This kind of policy bears limited risks when the underlying reason of the increase in asset prices is widespread optimistic expectations about future rises in productivity. If proven ex post that the optimistic private expectations were exaggerated, the prompt implementation of tighter policy at an early stage would be justified as capable of restricting the general unjustified optimism. If the monetary policymakers impose at an early stage tighter credit conditions, the increase in market valuations can be confined rendering the eventual collapse less

rkets participants, disruptive for the economy. On the other hand, if the expectations are confirmed ex post, then the increase in productivity and the enhanced growth prospects will diminish the cost from the tighter policy (ECB (2005), p. 58).